ETFs not more tax efficient than mutual funds

When investors check out North American literature espousing the benefits of exchange-traded funds (ETFs), they inevitably come across information extolling how tax efficient they are, especially compared with mutual funds. But in truth, with few – but notable – exceptions, Canadians looking for better tax efficiency from an ETF than a mutual fund are out of luck.

That’s because most ETFs are treated exactly the same as a mutual fund when it comes to paying taxes, says Christopher Doll, vice president of PowerShares, sales and strategy.

The messaging gets a little confusing when U.S. information trickles into Canada because ETFs are definitely more tax efficient than mutual funds there.

“[But] if you hold U.S. equities in a mutual fund [in Canada] you are going to pay taxes on the capital gains when they’re crystallized,” says Doll. “There’s going to be a withholding tax on the dividend income when that comes in and that will be taxed as foreign income. On the flip side: if you hold that same security in an ETF, it’s the exact same taxation.”

But both tax efficiency along with MERs are important to keep in mind since they can have a major impact on the long-term performance of a portfolio.

That’s why Toronto-based Horizons ETFs Management (Canada) introduced Total Return Index ETFs, also known as TRI ETFs. The company is the only ETF provider in Canada to offer TRI ETFs which use a synthetic swap structure that provides exposure to an index benchmark without physically holding the securities in that index.

“Instead of holding underlying stocks of the index, it enters into this total return swap with a large financial institution, which gives us the return on the index,” says Noble. “But because there are no stocks giving out distributions, you don’t have to pay tax on distributions. Instead you just have to pay out capital gains. It’s a lot of tax savings for an investor.”

Noble says Horizons has 12 ETFs using the total return swap structure, including U.S. equities, Canadian equities and fixed income. He believes this is one of Horizon’s fastest-growing families of ETFs for clients who use them in non-registered accounts to defer taxation on distributions until they sell.